BorgWarner Inc. (BWA) Earnings Call Transcript & Summary

Good morning, everybody. Thank you so much for joining us for this session with BorgWarner as part of Deutsche Bank's Global Automotive Conference. My name is Emmanuel Rosner. I'm the lead U.S. autos and auto technology analyst here at Deutsche Bank. I'm extremely pleased to be joined this morning by the senior management from BorgWarner. I have, to my right, Fred Lissalde, who's the CEO; and we have Patrick Kevin Nowlan, who is the EVP and CFO of the company. BorgWarner is a leading supplier of engineering systems and components, primarily for automotive powertrain applications. The company recently announced the split of its fuel systems and aftermarket business into a separate company, which will be a separate stock called PHINIA. BorgWarner is retaining the air management, the e-Propulsion, the drivetrain, the battery system. And then at Capital Markets Day just last week, it quote for these e-product revenues of $10 billion by 2027, which would be about half of the company sales by then and 10% margin sustainable towards the end of the decade. So extremely good timing to discuss all of this a week later and very much looking forward to the discussion.

So maybe just to kick things off specifically on the e-product side, which is essentially your solutions for vehicle electrification. You hosted this Investor Day last week. You provided a $10 billion target for eProducts revenue versus $2.5 billion this year. If you look at your awards across different geography, where is the growth coming from? And what percentage of business are you winning from components versus systems, global players versus local players, incumbents versus EV pure plays. Who's giving you business?

For that question. Can I go through a couple of slides to summarize the...

Absolutely. If I -- totally my mistake, if I didn't realize that -- this was just was the plan. I'm so into my question.

I'll address all the questions.

Absolutely. You do it. You can even do it from the podium if you want.

No, no, no. I just wanted to summarize the investor last week in building on the success that we have had for we're Charging Forward that we announced in March 2021, we announced an acceleration and an evolution of Challenging Forward, which we call Charging Forward 2027. And we have 3 key pillars, and we've set our sales targets. The first pillar, as you mentioned, Emmanuel, is $10 billion of eProducts in 2027. The second pillar, as you know, we're marching towards breaking even on those eProducts by the end of this year. And we want to set a target of 7% operating margin in 2027, marching, as you mentioned, to a sustainable double digit by the end of the decade. And last but not least, with the product that are foundational that remain after the spin of PHINIA, we want to maintain our strong margin and top growth line margin and really maximize the value of those foundational products. This is a picture of the product line that we've created since we announced product Charging Forward in March 2021 and also with the acquisition of Delphi Technologies. So what you can see here is that literally, we have products from [ grid to wheel ]. Wherever electrons go, we have products, some of them with a lot of scale, especially downstream the battery. Some of them we would take more scale, and we will. But what is very important is that what we do at BorgWarner is that we are solving for the efficiency challenges of a battery electric vehicle. We are focusing on product leadership in efficiency of moving vehicles with at least electrons as possible. That's what we do. That's what we've done for the past decade. So we call that fuel efficiency. Well, there is fuel in BEV, but efficiency in the BEV is, we think, even more important than the efficiency in a combustion engine because it touches the range or the size of the battery pack, then the cost, the competitiveness of the cars and the reduction of the supply chain issues. So we announced $10 billion in 2027, which, by the way, was the size of the overall company in 2019, just so that you have an idea on how fast we've moved. 42% of our revenue in battery electric vehicle vastly overweight versus market. We think the market is going to be around 32% in 2027 and 49% of eProducts. So I just want to make sure we all speak the same language on eProducts. What is a e-product? It's a product that goes into a BEV or a product that goes into a hybrid that could go into a BEV. For example, a motor that go into a BEV or hybrid, the same motor. We call that an e-product, a turbo that goes into a hybrid can't go into a BEV. It's not an e-product. And if you have us grow at market from 2027 to 2030, 2/3 of the company is going to be made with -- 2/3 of the company's revenue is going to be made with eProducts. Why would we reinvent the wheel? Launch quality is paramount when we grow that fast, which is using the locations that we have. Post PHINIA, we will have 60 plants have both on a very, very balanced across the 3 continents. Where we're using those plants? To launch eProducts. Why would we create a greenfield some with no knowledge of launching auto parts. So by 2026, we will have utilized 15 plants for eProducts, so about 25% of our allocation. So we're focusing a lot on capital transfer, transition and also human capital transition with several programs that we have to train and evolve our engineers and other populations from the world of combustion to the world of electrification. So long story short, this year, we guide at 9.4%. At the midpoint, in 2027, we get to double digit. What's really important in that chart is that it is a 55% increase from current year operating income, $750 million is the expected operating income between this year and 2027. That is what we believe is going to create long-term value for shareholders. So to summarize in a nutshell, EV is growing fast. We also moved fast, and we've created a product portfolio that is centered to solve the challenges of efficiency in BEVs. We've announced $10 billion of revenue in 2027. Beforehand, we announced $5.6 billion of revenue in 2025. And we put a market with 7% operating margin in 2027, marching to double digits by the end of the decade. I'll turn it back to you Emmanuel.

Thank you so much. So I guess let's go back appreciate -- but I go back to the question -- it could -- and by the way, standing room only, as you could see. So they're bringing chairs. I apologize, the chairs are coming as we speak. But definitely interest in the story, which is encouraging. Again, this e-product revenue targets, who are you winning them with? Is it systems? Is it components? Is it global players? Is it players that are less well capitalized and therefore, need you. Like, who is doing it in-house who's giving it to you.

So we've announced 29 wins so far. And you will see in our IR deck posted on the website that it's very balanced across the 3 continents, actually a lot in Asia, too, which is great for us. If you take -- we're winning in systems, but also we're winning in components, and it's perfectly fine. If you take the top 10 automakers in the world this year, and if you exclude the 3 Japanese, we actively work and grow in eProducts with 6 out of 7. If you take the top 3 commercial vehicle customers around the globe this year, we work actively and grow in eProducts with those top 3. So that shows you how big we are and how relevant we are in the marketplace.

If I look at your e-product revenue targets of $10 billion by 2027, where are you in terms of book to revenue?

So if you take the $10 billion that we announced in 2027, you need to back out $1.7 billion of M&A. So it's $8.3 billion of organic growth, $8.3 billion. We're at $5.6 billion booked business in 2025. So you can see that we're well underway to book the additional businesses to get to $8.3 billion in 2027 in the next few months and about 2 years.

And I guess the portion of the growth that's dependent on incremental M&A, I guess about $1 billion or so beyond the original correct Charging Forward plan. Where is this coming from? Are there technologies that you need?

So we're looking -- we're always looking at this from a technology standpoint that would enhance the efficiency of our products. you have an inverter that is more efficient, 2% or 3% than others, and we differentiate that way. It brings value to our customers and our customers already pay for it. So gaining scale in some of the products that you saw on the slide is also something that we look at, adding some presence in other regions where we are not totally having scale yet. So those are the vectors that you should think about when you think about additional M&A. Also, one point is engineering. Engineering talent is a key element for us. If we want to gain scale in power electronics upstream the battery, we're so busy with power electronic downstream the battery on inverters that acquisition that would break good -- a good team of engineers, we would certainly look at it.

What would you say is the biggest risk to the revenue outlook? What is your biggest concern?

So as the CEO of this company, I think my biggest concern is focusing on launch quality. We're growing very fast with products that we've not done a lot of in the past, actually. No one has done a lot of in the past. That's one of the reasons why we are transitioning our human capital and our production locations because they know how to launch auto parts. They know how to bring a laser focused eye on quality during the program management, and they know our customers. But that's what I would say and I would say it's the announced quality of our products around the globe that we were laser focused on. Yes.

Is there any risk around sourcing, especially for silicon carbide that could slow down your targeted growth? And if so, how do you mitigate it?

So we don't think so. We are happy with the work that we've done to secure the silicon carbide volume. As you may know, we have an agreement with Wolfspeed on a capacity corridor on silicon carbide which isn't that exclusive. So we're working with the other usual suspects that are also doing silicon carbide. And we think we are in a good place. If you look at the volume of inverters that we produced in 2027, about 6 million inverters. This is a lot of silicon carbide. And people want to work with us. And so we're working with suppliers that actually want to book business with BorgWarner.

So maybe just rewinding and focusing on the outlook for this year. The way you expressed it last week for BorgWarner RemainCo, I guess, not the piece that you will be retaining. Can you comment on this outlook? Are there any major changes versus the previous one you had provided in the first quarter? How are the industry and company conditions playing out for you? Is this as roughly as you expected?

Yes. I mean, fundamentally, nothing has changed. What we did versus the prior guide that we had given on our Q1 earnings call was to simply back out the PHINIA portion that was embedded in that guide. And so what's less than is truly just the RemainCo side that was embedded in that guide, which was $14.0 billion to $14.6 billion of revenue, about $2.3 billion to $2.6 billion of eProduct revenue in that. and that implies a 10% to 15% organic growth margin, 9.2% to 9.6%. So taking out PHINIA, which is a higher-margin business by itself, takes down our margin about 80 basis points, but still a top quartile margin business on that fast-growing revenue base.

And specifically in terms of industry conditions that you're facing, is it roughly the...

Nothing has materially changed in what we guided to a month ago. I mean we still look at low single-digit production growth this year.

If I look at the total company revenue outlook through 2027, so we closed for 10% revenue CAGR to then 10% operating margins by then, about 15% of your revenues at that point coming from eProduct. But if I assume it on the growth profile, it assumes 2% annual growth from acquisitions, so about 8% organic and then within that, some of it presumably is the industry volume growth assumption. So what is embedded in this sort of like long-term view? I'm trying to better understand your growth above market potential in both eProducts as well as combustion engine.

Yes. I mean our -- overall, we're very much focused on the high single-digit organic growth for the company on a go-forward basis. So it's roughly like you said, the 8% on a total basis. with so much change going on in platforms and propulsion technologies. I think so many things are changing. We just think that's the better way to think about it. But to answer your question, I mean, embedded in that outlook that 8% is effectively market going up somewhere in the 2% to 3% ZIP code. So on that traditional outgrowth metric, it probably looks like it's something in the 5% to 6% range. Now that includes the CAGR effectively on our eProduct portfolio organically growing well north of 30%, and when the CAGR for the TAM is probably more like 20%. And it has our foundational products outgrowing as well. I think, over that 4-year time frame, the TAM is coming down on the foundational product, probably about 15%, but you can see our revenue guide is effectively coming down over that same time frame, maybe about 6% at the midpoint. So we're outgrowing both of those markets effectively if you look at our revenue outlook versus the TAM. But again, we're very much focused on making sure we're positioned to be overweight the fastest-growing portion of the market, which we think will continue to contribute the high single-digit organic growth, which is really our focus.

Now your message on margin seems to be, we can maintain stable margins around 10% through the end of the decade, even as we have to invest a lot in e-R&D. And as your most profitable ICE business actually eventually declines. So on one hand, this is impressive, obviously. But on the other hand, is flat margins for the rest of the decade, is that enough, I guess, both as a target and as a message? And within that, why does e-R&D F2 stay as high as a percentage of revenues? Why can't this be offset by cuts in the foundational business R&D.

Well, let me take the second part of that question first. Just talk about the R&D. We manage R&D separately. We don't look at a pot of money that we decide how do we allocate it between E or our foundational businesses. So last year, we might have invested 5% in R&D, but it was a tale of 2 different types of business, call it 28% or so going into eProducts and something around 2.5% on the foundational side when you just cut through the math of it. So could foundational R&D management offset eProduct R&D growth? it could, but that's not really the way we manage the business. We really look at the 2 as distinct things. In terms of the margin profile of the business, as we're growing in eProducts, remember, we're launching a lot of new products. We're going from about $2.5 billion of eProduct revenue this year, growing at about $3 billion organically over the next 2 years and then almost another $3 billion organically over the succeeding 2 years. So there's almost $6 billion of organic growth of a $2.5 billion base. So there's a lot of launches going on during that time frame, products that we haven't launched in scale in the past. And we're pretty pleased with the fact that we're delivering 16% incrementals on that through '27, excluding the growth in new product-related R&D. And so that's why we're pleased with giving to the milestones of breakeven into this year, 7% in 2027, but that's not the end game. Then from there, it grows because we continue to contribute on incremental revenue and get to double-digit margins. The foundational side, I think, practically speaking, we have to acknowledge that as we start to see the eventual fall off in that revenue, like we start to see by 2027, it's going to tend to come with heavier decremental margins. And so we have to be out in front of making sure we're proactively managing that because as we disclosed in our Investor Day last week, we're at a 13% margin net of corporate costs right now on that foundational business, but it's not going to decrement at 13% without actions. Normally, it's probably going to decrement north of 20% without being proactive, which is part of the reason we're executing some of the restructuring actions we've talked about. That $80 million to $90 million, I mean think about it on revenue coming down about $800 million at the midpoint at 10 points of margin. So that's what helps cushion the blow on the way down. It allows us to sustain that 13% margin profile. So net-net, when you put it all together, it means 10% margin in 2027, but just as Fred showed, I think the more important point isn't whether 9.4% goes to 10% or to 9.7% or to 10.3%, it's that over that time, we're growing revenue $7 billion, 50% growth in revenue at a 10% top quartile margin, which means our earnings are growing $750 million. That's the real value equation. It's not whether it's 10%, 9.9% or 10.1%.

I guess I was just on a little bit on the eProduct margin progression. So your breakeven exiting this year, that's at least the goal on eProducts, moving to 7% adjusted operating margin by 2027. Based on the R&D moving to 7% of eProducts sales, from 19% or so this year. Again, what incremental margins you're assuming on higher revenues within eProducts. And this implies e-R&D of maybe about $475 million this year, growing although to $700 million in 2027 in absolute dollar terms. Can you give us a bit more visibility on how you deploy your resources and arrive at these figures?

Yes. So the incrementals that I just mentioned, ex the e-R&D, we're expecting that we're going to be growing about 16% or converting 16% on the incremental revenue over that time frame. But e-R&D is continuing to grow. So you're right, it's probably about $480 million, $190 million this year, so right around your numbers. And you're right, growing to about $700 million. But what's happening there is we're scaling revenue and growing it more quickly than the pace at which our R&D is growing, which is why R&D as a percent of sales is falling. It's going from 19% in '23 to 7% in 2027. And that's the scale effect of revenue growing more quickly and how we get to 7% margin from a loss-making position actually for the full year 2023, albeit breakeven by the end of the year. How do we get the visibility to that? We actually build this up program by program, revenue base, R&D base, we actually build that. It's a bottoms-up analysis, not a top-down analysis. So we know the resources that we need to support the product launches that we have underlying our long-range plan, and it syncs up with that $700 million or so.

And you then expect the eProduct to reach 10% operating margins by 2030? Is this as good as it gets? Like, is eProduct margin profile fundamentally lower than the current foundational margin? And if so, why?

The answer is it's not as good as it gets, and it's not fundamentally a lower margin necessarily than any of our other businesses. We price the business the same way we price our foundational businesses, which is any program that comes to Fred and me, 15% after-tax return on capital. And the capital intensity of the foundational programs and the e-programs from a capital perspective is substantially similar, which means the return profile over the life of any given program is the same. The issue that we face in the eProducts business is it's just still in rapid growth mode. We're still growing into the R&D. We're growing into the CapEx, which flows through depreciation. And that's what is a bit of an overhang on getting to your sustained margin at either 2027 or 2030. So as we progress to 2030, we expect to hit double digits. But at that point, we're still growing at 15% CAGR. And so as long as we're continuing to grow and we expect to continue to convert,, the margin continues to improve from there. So 10% isn't the end point, but 10% is an important milestone as well. And we're pretty pleased if we get to 10%, because that means double-digit margin, top quartile margin consistent with what you've seen from this company over time.

To be clear, fundamentally, you don't see any reason for e-business to be less profitable than your conventional business.

Not over the long term -- let's take a step back and talk R&D for a second because even in 2027, we're 7% R&D. And electronics does tend to run with a higher level of R&D than what you see in other businesses. But remember, when you think of R&D, R&D is not funding this year's revenue, it's funding revenue -- supporting revenue 3-plus years out. So when you look at that $700 million of R&D in 2027, it's not supporting that $10 billion of eProduct revenue. It's supporting the $15 billion to $16 billion in 2030. So as that revenue stops growing at 15%, maybe it starts to slow a little bit, you get even a little bit more leverage on that R&D than maybe you have in 2027 or even 2030. So it's a path to not just 10% but even more beyond that.

And then you presented various scenarios for revenue and margin trajectory by the end of the decade under various EV penetration assumption, which I think is very helpful as a framework. But the bottom line being in all these cases, you essentially get towards the 10% margin. So what brings you to this 10% margin even if the combustion engine were to decline faster.

And so we do a lot of scenario planning when we go out beyond our long-range plan because we obviously don't have a crystal ball to know exactly how the propulsion markets are going to play out. And so the scenarios we ran were what if EV penetration isn't as high as we thought or it's a lot stronger than we thought. So our baseline projection through 2030 is global EV production is at about 48% of the global market. If it's only at 40%, instead of 48%, what does that mean? It means the fastest-growing portion of the market that we're overweight in eProducts, isn't growing as quickly. So our revenue is probably growing a little bit more slowly, probably $1 billion less than what's in our baseline planning. But the place where we still have a stronger margin at that point is likely to be the foundational business. And so that business is holding up for a little bit longer because it's not declining as quickly in that horizon. That's why we think revenue under that scenario is a little bit lower but our margin percentage is probably a little bit higher in the low 10s. If you look at the opposite end of the spectrum, maybe EV penetration goes to 60% instead of 48%. But what happens? Well, good news for us from a revenue perspective, that's where we're positioned. We're overweight there. So we grow more quickly, but it probably means the foundational business is probably under a little bit more pressure and coming down more quickly with higher decrementals. And so those higher decrementals are more than offsetting the incrementals from a margin percentage perspective and probably pulling us down to mid-9s from a margin perspective. But whether it's mid-9s on higher revenue or low 10s on lower revenue, the message we're trying to convey is the portfolio is pretty resilient under any of those scenarios. Because the operating income that we throw off is somewhere in that $2.3 billion to $2.7 billion ZIP Code under any one of those scenarios. So we're pretty resilient under no matter where the EV penetration goes.

Speak about the -- what you call the foundational business, which is essentially the legacy and most profitable business so far. I think in your sort of like midterm assumption of 2027, you're seeing this foundational business, revenue declined by maybe $0.5 billion to $1 billion. Can you walk us through the layers of this? What would you expect, what business do you expect will sustain? What are declining? What may still actually be growing? Like isn't turbochargers still growing?

Yes. I think when you think about those businesses, you need to think about the fact that those key products are essential enablers of efficient hybrid powertrains. They're not eProducts, but everybody talks about BEV, and we talk about BEV and we love it. But there is a lot of hybrids around the world in all regions. And so that makes it such that those products are still in high demand. Two, you need 6 total suppliers in the world or does an OEM need 4 going forward? And who are you going to work with? So we think that we can also gain a little bit of market share in those products because we're very financially strong. We are committed to those products. And we're here to help our customers. We're not in the business of making deals here. We're in the business of multi-decade relationship with our customers, bridging each other from the world of combustion to every to electrification. So that's what I would say. Do you want to add anything?

And so you also announced and you mentioned this before, some plans to restructure and spend some restructuring money between now and 2027 to achieve annual savings of $80 million, $90 million by 2027. What does this plan look like? I guess what's required -- what needs to be done on the restructuring front?

I think it's really just looking at some of the foundational businesses where maybe we have an opportunity to reduce some of the fixed cost structure there. And so we do think that generates about $80 million to $90 million of annualized savings by the time we get to 2027 which helps mitigate the impact of the foundational revenue starting to come down at the back end of our planning horizon. And that's why we're able to sustain that margin profile.

It seems some of those are like front-end loaded that you can get some savings this year and then more like by 2025. And these are also the years where I would assume the foundational business is not actually declining yet. So what does the company-wide margin look like in 2025 versus heading into 10% in 2027. Does it go higher before it settles at 10%?

Yes. And we obviously didn't guide to the interim points, but I think it's fair to say, hey, we're getting some incremental benefit a little bit sooner from the restructuring actions and maybe the decline that you see in the foundational business is a little bit more at the back end. But really, the bigger driver of the margin profile that we see over the coming years is converting on that incremental $6 billion of organic growth over the next few years, of which almost $3 billion of it or so is coming in the next 2 years and then another $3 billion the following 2 years. That's really what we think ultimately pulls the margin profile up toward that 10% by 2027. The other wildcard that's in the mix when you think of the margin profile is the $1.7 billion or so of acquisitions that come in, when they come in and what the margin profile of those looks like at the time now. So that's part of the reason we're not guiding year by year. But I think it's fair to think it might -- it's not a hockey stick in 2027. It's probably something that more progresses from today, the 9.4% at the midpoint towards the 10% in '27.

So maybe to conclude, let's focus in your capital allocation. Under these targets between now and 2027, what does free cash flow look like?

We gave some color on free cash flow at the Investor Day last week. Over the 5 years from 2023 to 2027, we expect to generate about $3.5 billion of free cash flow. And that includes this year, which is effectively about $250 million to $350 million because we guided to $400 million to $500 million, but that's before the $150 million of onetime costs associated with the spin-off. So the midpoint of that, that $250 million to $350 million, you take that out says that we're generating about $3.2 billion of free cash flow over the succeeding 4 years. So we're pretty pleased with the cash flow generation that this company is going to generate while growing rapidly in the world of electrification and making those investments to support that growth.

In terms of allocation, you've also indicated that even though there's major investments that need to be made on eProduct as well some M&A, which we discussed before, you are still maintaining commitment to return capital to shareholders. Can you talk through the different pieces of the strategy?

I think that's been consistent with the company over time. We've had a balanced approach to capital allocation. If you look at the operating cash we've generated over the last 5, 6 years, we put about half of it back into the business in the form of CapEx, invested about 1/4 of it in M&A and about 1/4 of it returned to shareholders. And so -- and that's been supporting our growth strategy. So as we look ahead through 2027, we don't see that fundamental approach changing. And it starts with the commitment to returning value to shareholders. And we expect to have a dividend and policy in place post the PHINIA spin, where we'll continue to remit a dividend of about $100 million per year. We look at the buyback authorization that we still have in place, $0.5 billion remaining under that authorization. We'll continue to be opportunistic. We don't like to sit on cash that we don't have an eye towards how we're going to deploy it. So if we see opportunities like we did last year where we bought back $240 million, we'll look to do that. And then with the other $2.5 billion or so of cash that we expect to generate beyond what we would return to shareholders there, we want to maintain flexibility because the market is continuing to evolve and opportunities may arise that we don't even see on the radar today that we might think makes sense to either invest in organically inorganically if we don't see those opportunities, maybe more returns of that cash to shareholders. So I think that having some flexibility in the capital allocation strategy going forward is going to be important.

Great. So maybe to put it all together, Fred? What is the opportunity from this split. Where do you see this new BorgWarner going over the next few years.

You're going to hear what they have to say right after our split. It is simple. Those 2 companies we've created a position of strength, both very well capitalized. We have different strategies. We can't do it all. Management has to be laser focused in one strategy. We can't do hydrogen and aftermarket. And we want to be in BEV. We want to be in electrified powertrain and that takes a lot of energy. And they're going to be in aftermarket. They're going to be in commercial vehicle, which has a long tail, and they're going to be in hydrogen and all those injections in -- the means of injections, other means of different fuels. So both companies have great strategies. They have great -- well capitalized to pursue their own strategies. And we're very happy that we've been able to do that in a rather short period of time.

I think we have 2 minutes for a question in the room, if we have any. Otherwise, a quick room, Jim?

With your backlog wins, we're seeing some big enthusiasm for Tesla BYD type volume growth. And then a lot of angst about who might really lose a lot of volume or not get the volume they expect. So 2 questions. One, are there certain programs or customers that you're overly weighted to that have to execute and succeed and/or from a manufacturing standpoint, you have so much flexibility and such a diversified customer base in EVs, you can kind of weather any of those potential issues. So kind of 2 parts to that question.

Yes. We -- as I mentioned before, we work with pretty much everyone around the world, right? And so we're focusing on modular design. We're focusing on modular production, flexible production. So we manufacture in the region. We're not shipping final products across continents. So we think we have the right flexibility and you look at the scale that we're going to have, right? We having go to 7 million high-voltage [ points ] and more than billion in battery pack. So we're not worried about that. We have the right diversity from a customer and regional perspective that allows us to be feeling protected.

Have you commented on Tesla or BYD revenue exposure?

We have not -- but we are working with 1 of those 2 names.

On electrified propulsion.

Awesome. Well, thank you so much for being here. Thank you and good luck with the transformation, July 5th.